self-employment tax and niit for llcs and higher income...

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Self-Employment Tax and NIIT for LLCs and Higher

Income Individuals: Navigating the Complex InterplayTUESDAY, DECEMBER 8, 2015, 1:00-2:50 pm Eastern

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Dec. 8, 2015

Self-Employment Tax and NIIT for LLCs and Higher Income Individuals

James R. Browne, Partner

Strasburger & Price

[email protected]

Cameron Hess, Sr. Principal

Wagner Kirkman Blaine Klomparens & Youmans

[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

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RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Cameron Hess Jim BrowneCameron HessWAGNER KIRKMAN BLAINE

KLOMPARENS & YOUMANS LLP

Mather, CA

916.920-5286 x810

[email protected]

Jim BrowneSTRASBURGER & PRICE, LLP

Dallas, TX

[email protected]

December 8, 2015

AgendaAgenda� Introduction

� Self-employment tax implications for LLC members

� Treatment of limited partners under 3.8% taxes

� Planning opportunities� Planning opportunities

� Proposals and changes on the horizon

6

IntroductionIntroduction

7

IntroductionIntroduction� Supplemental Taxes (before 2013)

� FICA/SET

� Employment tax on wages (“FICA”)� 15.3% on base amount (indexed)*; 2.9% on excess

� Paid ½ by employer and ½ by employee� Paid ½ by employer and ½ by employee

� Tax on earnings from self-employment (“SET”)� 15.3% on base amount (indexed and adjusted for wages); 2.9% on excess

� Investment income� No supplemental tax

*$110,100 for 2012

8

IntroductionIntroduction� Supplemental Taxes (current law 2013)

� FICA/SET/Medicare/NII� Employment tax on wages (“FICA”)

� 15.3% on base amount (indexed)*; 2.9% on excess� Paid ½ by employer and ½ by employee

Additional 0.9% employee tax on excess wages of high-income � Additional 0.9% employee tax on excess wages of high-income individuals

� Tax on earnings from self-employment (“SET”)� 15.3% on base amount (indexed and adjusted for wage income); 2.9% on

excess� Additional 0.9% tax on excess self-employment earnings of high-income

individuals

� Investment income� 3.8% tax on net investment income of certain high-income taxpayers*

*$118,500 for 2015

9

IntroductionIntroduction� Application of FICA and SET additional tax

� Affected (high-income) taxpayers

� Individuals with wages and/or self-employment income in excess of:

� $250,000 joint$250,000 joint

� $125,000 separate

� $200,000 individual and other

� Additional tax applies only to the aggregate wages and self-employment income in excess of the specified amounts

� Thresholds are not indexed for inflation

� Corporations, estates, and trusts are exempt

� Additional tax is subject to withholding or estimated tax payments along with regular FICA or SET

10

Introduction Introduction -- NII “basics”NII “basics”� Additional Tax – Starting 1/1/2013.� Applies to: individuals, estates and trusts

and: Sch K-1 entity reporting

� Compute 3.8% Additional Tax x the lesser of:� Compute 3.8% Additional Tax x the lesser of:� (1) Total NII (net investment income), or

� (2) Excess MAGI*

*Excess MAGI = “MAGI minus Threshold Amount.- (Except US persons overseas, MAGI = AGI – Line 31 Form 1040.)

Total NII is after deduction for portion of Sched A, Form 1040 expenses (investment expenses, alloc. state income taxes)

11

Individuals Individuals -- Threshold AmountThreshold Amount

Status

Threshold

Amount

Married filing jointly $250,000Married filing jointly $250,000

Married filing separately $125,000

Single $200,000

Head of household $200,000

Qualifying widow(er) with child $250,000

12

Trusts/Estates Trusts/Estates -- Threshold Am’tThreshold Am’t

�2015: $12,300 - CPI indexed ($12,450?-2016)

�Compare to individuals:�Compare to individuals:

� 12,300 vs 125K/200K/250K

�Beneficiary distributions (of DNI) generally reduces the NIIT to trust/estate

� NII then passes to beneficiary

13

Example 1 Example 1 –– IndividualIndividual

Big John (unmarried, in US) has � $300,000 NII (rental income)

� $190,000 AGI (had a business loss)

� 3.8% NIIT Computation:

� NII Tax = $0.

� 3.8% x lesser of (1) $300K NII or (2) $0.0* *(190K AGI – 200K Threshold)

14

Example 1a Example 1a –– Irrev. Trust Irrev. Trust BJ Irrevocable Trust has

� $300K NII; $190K AGI (business loss)

� No beneficiary distribution (no DNI Distribution)

� 3.8% NIIT Computation:

� NII Tax = $6,752.60.

� 3.8% x lesser of (1) $300K NII or (2) $177,700* *(190,000 MAGI – 12,300 Threshold)

� But, if $177,850 DNI distributed, � NII Tax = $0.0 ($12,150 AGI)

15

IntroductionIntroduction� Application of NIIT (con’t)

� Exempt taxpayers: Corps, foreign trusts, and TE or charitable trusts

� Partnerships and S corporations are not subject to NIIT, but � Partnerships and S corporations are not subject to NIIT, but the income of such entities may be subject to NIIT in the hands of the owners

� Distributions from foreign trusts may be subject to NIIT in the hands of the beneficiary

� SET overlap: NII excludes income subject to SE tax

� Estimated tax: NIIT included in calculation of required installments

16

IntroductionIntroduction

NII = “Gross Investment Income (GII)” less:

“Allowable Deductions”

� GII Categories:� GII Categories:

� 1. Portfolio Income § 163 – SAME RULES

� 2. PAL/PIG § 469 – FEW CHANGES

� 3. Finance/Commodity traders-SAME RULES

� NOT “day traders”.

� Reduces value of security/commodity traders tax benefits

� 4. Net Gain (Dispositions) – LOTS OF CHANGES

17

Allowable DeductionsAllowable Deductions� Normal related deductions (e.g., expenses for rentals)

� “1040 Schedule A” deductions (phase-outs)

� State Income Taxes (allocate)

Investment Interest Expenses (related)� Investment Interest Expenses (related)

� Other investment expenses (e.g., advisor fees) (related)

18

IntroductionIntroduction� Common types of excluded income

� Interest income on tax exempt bonds

� Income from qualified retirement plans

� Social security benefits� Social security benefits

� Alimony

� Wages and self-employment income

19

Self-employment tax implications for LLC membersmembers

20

SET on LLC MembersSET on LLC Members� Issue:

� Can an LLC member treat any portion of the member’s distributive share of LLC income as exempt from SET under the exception for limited partner distributive share under the exception for limited partner distributive share income?

The issue is relevant only for LLC members who materially participate in the LLC business or can otherwise avoid NIIT on the distributive share income

21

SET on LLC MembersSET on LLC Members� The SET limited partner exception - 1402(a)(13)

� In computing net earnings from self-employment:� Include the “distributive share (whether or not distributed) of

income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member”business carried on by a partnership of which he is a member”

� Exclude (in addition to normal exclusions for rents, dividends, gains, etc.):

� “the distributive share of any item of income or loss of a limited partner, as such,

� other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services”

22

SET on LLC MembersSET on LLC Members� Purpose for the limited partner exception

� Before enactment of 1402(a)(13) in 1977, persons ineligible for social security benefits were buying passive, limited liability investments in partnerships that promised to generate self-employment income eligible for such benefitsemployment income eligible for such benefits

� Congress enacted 1402(a)(13) to curtail “buying” social security benefits through limited partner investments

� While the statute targets passive limited partners earning investment type income, the statute is not limited to such persons� The statute expressly contemplates that a limited partner

may provide services to the partnership and earn a guaranteed payment for such services and still have distributive share income excluded from SET and related benefit accruals

23

SET on LLC MembersSET on LLC Members� The 1997 proposed regulations

� Context: � Traditional restrictions on limited partner management activities

eroding� Growing use of alternative forms of tax partnerships with full or partial

limited liability for managing members (LLCs, LLPs, and LLLPs)limited liability for managing members (LLCs, LLPs, and LLLPs)� Increasing SET rate relative to benefits

� General rule: a “limited partner” is any individual unless the individual:� has personal liability as a partner for the partnership’s debts, or� has authority (under the law of the jurisdiction in which the partnership

is formed) to contract for the partnership, or� participates in the partnership's business for more than 500 hours

during the partnership’s taxable year, or� is a service partner in a service partnership

24

SET on LLC MembersSET on LLC Members� The 1997 proposed regulations (con’t)

� Class of Interest Exceptions� An individual holding more than one class of interest is a limited

partner with respect to a class of interest in which (a) limited partners (as defined above) own a substantial (≥20%), continuing interest and (b) the individual’s rights are identical to such limited interest and (b) the individual’s rights are identical to such limited partners’ rights

� An individual holding only one class of interest who is not a limited partner solely because he participates in the business for >500 hours is a limited partner with respect to the interest if (a) and (b) above are true with respect to the class of interest

� These exceptions are intended to “exclude from an individual's net earnings from self-employment amounts that are demonstrably returns on capital invested in the partnership”

� A service partner in a service partnership is never a limited partner to any extent (i.e., no class of interest exception)

25

SET on LLC MembersSET on LLC Members� Congress responds

� The 1997 proposed regulations sparked a firestorm of criticism� Critics claimed that earnings from self-employment must be limited

to the fair value of the services actually rendered to the business, and should not sweep in all income derived from the business based on should not sweep in all income derived from the business based on arbitrary factors such as the number or hours worked or the nature of the business

� Congress promptly passed legislation prohibiting finalization of regulations with respect to the definition of limited partner under 1402(a)(13) until July 1, 1998

� The Senate bill expressed the Senate’s view that the proposed regulations should be withdrawn and that “Congress should determine the tax law governing self-employment income”

26

SET on LLC MembersSET on LLC Members� Case law and rulings

� Passive activity loss cases

� Several cases (see slide 47) address the question whether an LLC member is a “limited partner” for purposes of the passive activity loss rules (material participation test) [Reg. 1.469-5T(e)]loss rules (material participation test) [Reg. 1.469-5T(e)]

� All cases hold that an LLC member is not a limited partner

� Could those cases be applied in the context of 1402(a)(13)?

� The reasoning of the cases is dubious and was likely influenced by the questionable validity of the temporary regulations, which were modified in 2011

� Should not be authoritative for SET purposes

27

SET on LLC MembersSET on LLC Members� Case law and rulings (con’t)

� SET cases and rulings� Renkemeyer, Campbell & Weaver, LLP v. Comm’r, 136 T.C. 137 (2011)

� Law firm organized as a general partnership electing LLP status

� Abusive facts: transitory corporate holding company; missing � Abusive facts: transitory corporate holding company; missing partnership agreement; failure to allocate income and distributions according to alleged sharing ratios; low or no compensation for services

� Dubious reasoning: Court discusses the legislative history of 1402(a)(13)

� Intent to exclude “earnings that are basically of an investment nature”

� The legislative history “does not support a holding thatCongress contemplated excluding partners who performed services for a partnership in their capacity as partners”

� Because the taxpayers’ distributive share income arose exclusively from legal services performed on behalf of the partnership, and was not “of an investment nature,” the income was subject to SET

28


� SET cases and rulings� Riether v. United States, 919 F. Supp. 2d 1140 (D. NM 2012)

� LLC operates a medical diagnostic imaging business; members receive wages and distributive share income from the LLC; no SET on distributive share (<$10,000 tax effect)distributive share (<$10,000 tax effect)

� Taxpayers assert they can’t be self-employed because they received wages

� No evidence that members lacked management authority, or that wages were reasonable compensation for services

� Held: distributive share income is subject to SET because taxpayers were effectively general partners� “Plaintiffs are not members of a limited partnership, nor do they resemble

limited partners, which are those who ‘lack management powers but enjoy immunity from liability for debts of the partnership.’ [Renkemeyer] Thus, whether Plaintiffs were active or passive in the production of the LLC's earnings, those earnings were self-employment income.”

29


� SET cases and rulings� Howell v. Comm’r, 2012 T.C. Memo 303

� Medical technology company (LLC) formed by W and B; H (W’s spouse) managed the business with B; LLC paid guaranteed payments to H, B, W and others, leaving only small amounts of distributive to H, B, W and others, leaving only small amounts of distributive share income for W and B; no SET paid on guaranteed payments

� H&W “appear to contend” that W was a limited partner not active in the business and her guaranteed payments were either limited partner distributive share income or not payments for services

� Held:� Taxpayers are bound by their tax reporting (guaranteed

payment)� W performed some services for the LLC, but failed to prove what

portion of the guaranteed payments were for services� Notably, no SET imposed on distributive share income

30


� SET cases and rulings� CCA 201436049 (May 20, 2014)

� Investment fund management company organized as an LLC; members were paid a salary, a guaranteed payment for parking and health benefits, and a distributive share; no SET on distributive sharehealth benefits, and a distributive share; no SET on distributive share

� Members contributed varying amounts of capital to the LLC� Held: entire distributive share income is subject to SET because the

income “is not income which is basically of an investment natureof the sort that Congress sought to exclude from [SET] when it enacted the predecessor to § 1402(a)(13). Accordingly, [the members] are not limited partners within the meaning of § 1402(a)(13).”� No analysis whether the salary and guaranteed payments

represented reasonable compensation for services� No analysis whether the distributive share income was attributable

to capital contributions, profits on employee labor, or other non-service factors

31

SET on LLC MembersSET on LLC Members� Where are we now?

� Reporting position: an LLC member’s distributive share income from a manager-managed LLC is exempt from SET if the member is paid reasonable compensation for services as a managermanager� This position is easily reconciled with the statute and legislative

history, including the arguments that led to the 1997 Congressional moratorium

� It is consistent with the treatment of S corporations� It is consistent with the recent cases on their facts� IRS position that distributive share income of an active partner is

always subject to SET is plainly contrary to the statute, Congressional intent (as expressed in 1997), and its litigating position in Howell

� Service partners in service partnerships have more risk

32

Treatment of Limited Partners Under 3.8% Taxes Including NIITIncluding NIIT

33

Review BasicsReview Basics

� Effective 1/1/2013.

� Applies to: individuals, estates and trusts

and: Sch K-1 entity reporting

� Compute 3.8% Additional Tax x the lesser of:

� (1) Total NII (net investment income), or

� (2) Excess MAGI*

*Excess MAGI = “MAGI minus Threshold Amount.

34

NII Tax and Business EntitiesNII Tax and Business Entities

� Not a Corporate/Partnership Level Tax

� PSC/Closely Held “C” Corps

� Subject to § 469 – PAL Limitations� Subject to § 469 – PAL Limitations

� But Not NIIT

35

NII Tax and Business EntitiesNII Tax and Business Entities

� S Corp Holders/Partners (Indiv/Trusts/Estates)

HAVE NII PASSHROUGH (K-1) Including:

� 1. Portfolio Income § 163 � 1. Portfolio Income § 163

� 2. PAL/PIG § 469

� 3. Finance/Commodity Traders Income

� 4. Net Gain (Dispositions)

36

PassPass--Through to PartnersThrough to Partners

� NII results if partner’s T/B income

= passive activity (§469).

� IRS Statement – Will NOT follow all §469 exceptions:

� “Even if the taxpayer meets one of the

exceptions in Section 1.4691-T(e)(3)(ii), if the

taxpayer’s activity is not a section 162 trade or

business, gross income from rents will be

subject to Section 1411(c)(1)(A)(i).

37


Real Estate ProfessionalReal Estate Professional

� IRS will not apply following 469 active T/B presum’ns:� § 1.469-1T(e)(3)(ii) (Deemed T/B - 6 items)

� “Start-up” activity presumed T/B

� “Predevelopment revenue” � Not active T/B for NII� “Predevelopment revenue” � Not active T/B for NII

Example 3b: Developer leaseback to farmer land held for

development. While not passive under Section 469, rental

income will be deemed NII.

� Note – expect developers to claim

they are farmers.

38

PassPass--Through Through to Partnersto Partners

Real Real Estate Estate ProfessionalProfessional� 1.469-5T(a)(1) Safe Harbor Allowed:

� Real estate professional (>750 hrs) +� 1. participates in rental real estate activities;� 1. participates in rental real estate activities;� 2. time in activity = > than 500 hours per year,� 3. income associated with that activity*

� ��Active T/B , and thus not subject to §1411.

� *Activity Must be Part of That Active Trade or Business

39


Real Real Estate Estate ProfessionalProfessional�Alternate Safe Harbor Allowed:

� Real estate professional (>750 hrs) +� 1. participates in rental real estate activities;� 1. participates in rental real estate activities;� 2. > than 500 hours/year in 5 of 10 prior years,� 3. income associated with that activity*

� ��Active T/B , and thus not subject to §1411.


40


Real Real Estate Estate ProfessionalProfessional� Non-Safe - General Rule:

� Real estate professional (>750 hrs) +� 1. participates in rental real estate activities;� 1. participates in rental real estate activities;� 2. rental activities are substantial,� 3. income associated with that activity*� 4. derived in the ordinary course of a trade/business

� If prove it’s a T/B , then it’s not subject to §1411.


41


Limited Partner ProblemLimited Partner Problem� BUT: Limited Partners: §469(h)(2)

Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an partnership as a limited partner shall be treated as an interest with respect to which the taxpayer materially participates.

� And 469(h)(6)(c) says the same thing as to activeparticipation.

42


Limited Partner ProblemLimited Partner Problem� Two Part Analysis to Get Around:

1. Is the interest “classified” as a limited partner interest for tax purposes?for tax purposes?

2. If “classified”, does the limited partner meet one of 3 exceptions?

43


Limited Partner ProblemLimited Partner Problem� So, to avoid NIIT, partner must both:

� qualify as real estate professional and

� either (i) NOT be deemed a limited partner, or

(ii) meet an exception due to substantial activities.(ii) meet an exception due to substantial activities.

� Affected: Interests in LLCs, LPs, LLPs, LLLPs, other entities treated as “partnership”.

� Definition of Limited Partners by Statute? � NO. Not found under Section 469, 7701, or 1402(a)(13)

(self-employment tax exception)

44


Limited Partner ProblemLimited Partner Problem� How classify/“define” a limited partner.

� State Law vs. Tax Law

� Old Kintner Regulations not useful:

� Continuity of Life� Continuity of Life

� Transferability limitations?

� Limited liability

� Centralized Management

� Littriello v. US (6th Cir. 2007). Treasury does not have to follow state law for taxpayer-businesses; and can set own rules where Congress not clear and unambiguous.

45

PassPass--Through Through -- R/E ProfessionalR/E Professional

Limited Partner ProblemLimited Partner Problem� Limited Partner Defined: Temp Reg. 1.469-5T(e)(3)(i)

...interest [is] a limited partnership interest if—

(A) …. designated a limited partnership interest in the (A) …. designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, ….; or

(B) The liability of the holder … for obligations of the partnership is limited, …..

… interest … shall not be treated as a limited partnership interest …. if the individual is a general partner.

46


Limited Partner ProblemLimited Partner Problem� But courts declined LP treatment for LLC members:

Gregg v. U.S., 186 F.Supp.2d 1123 (D. Or. 2000). LLC.Garnett v. Com’r, 132 T.C. 368 (2009). LLPs and LLCs were not limited partnerships. not limited partnerships. Thompson v. U.S., 87 Fed. Cl. 728 (2009). 469(h)(2) requires a partnership. An LLC member is not a limited partner.Newell v. Com’r, T.C. Memo. 2010-23. 469(h)(2) did not apply to the managing member of an LLC. Member is a general partner under §1.469-5T(e)(3)(ii). Lamas v. Com’r, T.C. Memo 2015-59. Several LLCs & S Corp. Rejects no material participation. Aggregates S Corps & LLC activities – total hours adequate.

47


Limited Partner ProblemLimited Partner Problem� But Proposed Treas. Reg. 1.469-5(e)(3)(i) (11/28/11)

...interest [is] a limited partnership interest if—

(A) The entity…is classified as a partnership for (A) The entity…is classified as a partnership for Federal income tax purposes under §301.7701-3; and

(B) The holder of such interest does not have rights to manage the entity…..

IRS listed as 2015-2016 priority project July 2015.

http://www.irs.gov/pub/irs-utl/2015-2016_pgp_initial.pdf

48


Limited Partner ProblemLimited Partner Problem� If interest is “classified” as a limited partner, IRC §

469(h)(2) presumes interest is per se passive.

� Three exceptions:

� Taxpayer works 500 hours or more in the particular� Taxpayer works 500 hours or more in the particulartrade or business activity.

� Taxpayer materially participated in the activity in any 5 of the prior 10 years.

� It is a personal service activity; taxpayer materially participated in that activity in any 3 prior years.

� Did the IRS eliminate test #3 for NII purposes???

49

Related Issue Related Issue -- TrusteesTrustees

BasicsBasics

�Same rules

�Threshold Amount:

�2015: $12,300 - CPI indexed �2015: $12,300 - CPI indexed

�2016 $12,450?

�Distributions of DNI also pass-through NII to beneficiaries.

50

Related Related –– Trustees as R/E ProfessionalTrustees as R/E Professional

�Example: Trust owns % in LLC.

�Trustee = limited partner?

�Can Trustee materially participate?�Can Trustee materially participate?

� IRS Declined to Issue Regulations

� IRS position vs. taxpayers

51

Trustee Trustee Material ParticipationMaterial Participation

� IRS: Material participation by nongrantor trust depends on

trustee’s activity, not it’s agents (or special trustee) 1. BUT1Position discussed by IRS in TAM 200733023; PLR 201029014; TAM 201317010.

� Carter Trust v. US 256 F. Supp. 2d 536 (N.D. Tex. 2003). Trustee hired ranch manager. Material participation found through employees and trustee.

� Aragona Trust v. Com’r, 142 TC. 9 (3/27/14). 3 of 6 trustees (related) worked FT for R/E management LLC, wholly owned by trust. Trust can materially participate through trustee-employees; R/E professional exception applied.

52

Limited Partner/Trust RulesLimited Partner/Trust Rules� Same Issue/Same Framework?

� Material Participation & Real Estate Professional:

� Partnership - Determined at Partner Level

Trust – Determined at Trustee Level (if trustee does � Trust – Determined at Trustee Level (if trustee does material activities + agents activities.

� Unclear:

� R/E Pro Exception – Trust. If agents provide services, are they counted?

� Beneficiaries. If NO NIIT @ Trust Level, is income treated as “active” for beneficiaries @ distribution?

53

Roth/IRAs & NIITRoth/IRAs & NIIT� Distributions from IRA/Roth not s/t 3.8% NIIT

� Can hold Real Estate as Investment

� Caution: real estate held poses possible issues:

� UBIT (Tax at Trust Rates – 39.6% @ $12,300 TI)� UBIT (Tax at Trust Rates – 39.6% @ $12,300 TI)

� Actively “Trade”– Plan Disqualification

� Inurnment – Plan Disqualification

� Prohibited Self-Dealing

� No Capital Gains

� Schieck, Structuring Real Estate Investments to Avoid the Net Investment Tax, 41 J. Real Estate Tax’n (Q1 2014)

54

Planning OpportunitiesPlanning Opportunities

55

Planning Planning Trap #1Trap #1� Using an S corporation to avoid SET/NIIT

� The properly determined distributive share income of an S corporation engaged in an active non-trading business is unquestionably exempt from both SET and NIIT

� BUT� S corporations have significant disadvantages. (e.g., one class

of stock, no entity or foreign shareholders, no 754 election, no 721/731 exclusion for gain on property contributions and distributions, no inside basis step-up at death, etc.)

� The perceived SET/NIIT benefits may be overstated

� A properly structured LLC/LP should achieve similar SET benefits.

56

Planning Planning Trap #2Trap #2� S corporation election for an LLC or LP

� Tax preparers or other tax advisors often elect S corporation status for an LLC or LP solely to obtain SET and NIIT advantages. This is usually bad advice!and NIIT advantages. This is usually bad advice!

� Same considerations as any S corporation (see prior slide)

� Plus additional potential problems if the company agreement is not modified to conform to S corporation requirements; the entity might be classified as a C corporation!

57

Planning Planning Trap #3Trap #3� S corporation blocker

� What if the LLC/LP interests are owned by single member S corps?

Individual A Individual B Individual C

� Individuals are employees of LLC or S corp and are paid wages� Distributive share income flows through S corporations� NB: Cumbersome and does not eliminate all disadvantages of

S corporation ownership

S Corp 1 S Corp 2 S Corp 3

S Corp. S Corp. S Corp.

LLC

Partnership

58

Planning OpportunitiesPlanning Opportunities� A properly structured LLC/LP

Individual A Individual B Individual C

� Individuals perform services for LLC as employees of Manager� Distributive share income received by individuals as an LLC

member having no management rights� Same structure can be used for a limited partnership

(Manager is the general partner)

59

Manager

S Corp. (or LLC)

Manager-Managed LLC

Partnership

ManagementFees

Planning OpportunitiesPlanning Opportunities� Spousal split ownership of LLC/LP

Taxpayer Spouse

ManagingMember Member

� T’s activities are imputed to S for passive activity purposes, but are not imputed to S for purposes of SET limited partner proposed regulations

� S’s distributive share income should avoid SET/NIIT

60

OpCo, LLC

Partnership

Active non-trading, non-

service business

Member1%

Member99%

GuaranteedPayment for

Services

Planning OpportunitiesPlanning Opportunities� One class of interest exception

Taxpayer Others

ManagingMember Member

≥

� T’s distributive share income is exempt from SET under one class of interest exception, and is exempt from NIIT based on material participation

61

OpCo, LLC

Partnership

Active non-trading, non-

service business

Member

≤ 80%

Member

≥ 20%GuaranteedPayment for

Services

Planning OpportunitiesPlanning Opportunities� Grouping

� One or more business activities may be treated as a single activity (“grouped”) if the activities constitute an “appropriate economic unit” for the measurement of gain or loss for purposes of Section 469 [Reg. 1.469-4(c)(1)]

Appropriate economic unit depends on facts and circumstances� Appropriate economic unit depends on facts and circumstances� Generally, use any reasonable method to group activities� Five factors are given the greatest weight in determining whether

activities constitute an appropriate economic unit:� Similarities or differences in the types of businesses;� Extent of common control;� Extent of common ownership;� Geographical location; and� Interdependence of the activities

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Planning OpportunitiesPlanning Opportunities� Limitations on grouping

� A rental activity can’t be grouped with a trade or business activity unless they form an appropriate economic unit and

� Rental activity is insubstantial in relation to business activity;Rental activity is insubstantial in relation to business activity;

� Business activity is insubstantial in relation to rental activity; or

� Common ownership

� Can’t group real property rental activity with personal property rental activity

� Special rules for special industry activities described in Section 465(c)(2) (film, depreciable person property leasing, farming, oil and gas, and geothermal property)

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Planning OpportunitiesPlanning Opportunities� Special NIIT re-grouping election

� A one-time regrouping election is available during the first taxable year that NII exceeds the threshold amounts (first time Form 8960 would be filed) [Reg. 1.469-11(b)(3)(iv)](first time Form 8960 would be filed) [Reg. 1.469-11(b)(3)(iv)]

� Taxpayers may regroup on an amended return if the taxpayer was not subject to NIIT on original return (or previously amended return) and, if, due to a change to the original return, the taxpayer owed NIIT for that taxable year

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Planning OpportunitiesPlanning Opportunities� Limitations on grouping

� Final regulations do NOT allow regrouping by partnershipsand S corporations

� Opportunity for regrouping – 2nd Bite (different taxpayer)� Opportunity for regrouping – 2 Bite (different taxpayer)

� Estate/Trust @ 1st Spouse’s Death

� Sub-Trust Funded for Children

� Distribution of property out of trust/estate

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Planning OpportunitiesPlanning Opportunities� Planning

� Under prior law, it was often advantageous to not group activities (to accelerate use of suspended losses on activities sold or terminated)activities sold or terminated)

� Under current law, it might be beneficial to group activities so that otherwise passive activities that do not generate self-employment income can become part of an Active Non-Trading Business that generates neither NII nor self-employment income

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Planning OpportunitiesPlanning Opportunities� Self Charged Interest.

� On self-charged interest from an active (non-passive) business entity, a portion of interest income will be excluded.excluded.

� The exclusion amount = the lender’s “share of the nonpassive deduction”. The rule cross-references §1.469–7 for the operative mechanics.

� The limit is inapplicable if the interest deduction is part of a self-employment income computation (subject to tax under section 1401(b)).

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Planning OpportunitiesPlanning Opportunities� Self Charged Interest.

� Example. Able Designer loans $100,000 @ 10% to an architecture firm in which he owns 15% of the architecture firm located in the same building. Will architecture firm located in the same building. Will 100% of the $$ interest paid by the firm be treated as self-charged rent?

� No. There is only excluded the income = to the % interest deduction born. Only $1,500 of the $10,000 received will be excluded. $8,500 of the interest will remain NII

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Planning OpportunitiesPlanning Opportunities� Property s/t “Self-Charged” Rent

� Rental income treated as non-passive under §1.469–2(f)(6) (rental income from property used in an activity in which the taxpayer materially participates), including in which the taxpayer materially participates), including rental property grouped with a non-passive activity, will be deed T/B income.

� Gain/loss from rental property, if sold with active T/B property will also be treated as nonpassive T/B gain

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Planning OpportunitiesPlanning Opportunities� Property s/t “Self-Charged” Rent

� Example. Able Designer owns 100% of a building and 15% of the architecture firm located in the same 15% of the architecture firm located in the same building. Will 100% of the $$ rent paid by the firm be treated as self-charged rent?

Yes, under 1.469-2(f)(6), amount of rent paid by the firm will be treated as non-passive. The self-rental regulations do not require “mirror” ownership.

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Planning OpportunitiesPlanning Opportunities� Avoiding NIIT through material participation

� Participation by Hours > 500

� Time spent (Self/Spouse)

� Proof of Participation. Appointment book calendar, or � Proof of Participation. Appointment book calendar, or narrative summary. To show the services performed & hours.

� Facts & Circumstances Test (difficult)

� Activity regular, continuous, and substantial

� Works at least 100 hours in the activity,

� No one else works more hours

� No one else receives compensation for managing the activity

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Planning OpportunitiesPlanning Opportunities� Exclusions

� Per IRS – Exclude:

� Time to i) review financial statements, ii) analysis for personal use, and iii) monitoring (non-managerial) capacity does not count

� Owner work that would normally be assigned to an employee

� Travel Time Thomas E. Truskowsky, T.C. Summary Op 2003-130

� Per IRS: Few taxpayers can meet the facts and circumstances standard. If there is paid on-site management, the facts and circumstances test cannot be used.

� Are these position over-reaching? An on-site manager for 100 unit apartment defeats active T or B!!???

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Planning OpportunitiesPlanning Opportunities� Significant participation “sweet spot”

� A high income individual having a non-managing LP/LLC interest in a passive activity can generally avoid SET and NIIT on distributive share income if participation in the activity exceeds 100 hours but is less participation in the activity exceeds 100 hours but is less than 500 hours (i.e., is significant but not material)

� The individual’s distributive share income is exempt from SET (unless the individual has management authority or is a service partner in a service partnership) [Prop. Reg. 1.1402(a)-2]

� The individual’s distributive share income may be exempt from NIIT under the income recharacterization rules for profitable significant participation activities [Reg. 1.1411-5(b)(2)(i)]

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Planning OpportunitiesPlanning Opportunities� Net Gain from Dispositions

� Opportunities to reduce losses by:

� Strategies to reduce NII by Sec.165 losses: abandonment and

worthlessness. worthlessness.

� Culling of losses.

� Basic exceptions/limitations/exclusions apply

� Loss limitations (at risk, basis, but capital loss C/F rules are

narrower)

� Installment sale rules

� Statutory Exclusions apply – 1031/1033/1038/121(home)

� Look Through Rule:……

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Business Business DispoDispo LookLook--Through RuleThrough Rule� Owner’s “Disposition” of Interest in Pship or S Corp

� 1411(c)(4) & (Prop. Treas. Reg. 1.1411-7).

� Recasts NII gain/loss as business gain/loss.

In the case of a disposition of an interest in a partnership or In the case of a disposition of an interest in a partnership or an S corporation –

(A) gain from such a disposition shall be taken into account…only to the extent of the net gain…if all property of the partnership or S corporation were sold at fair market value immediately before the disposition of such interest, and

(B) a rule similar to the rule of subparagraph (A) shall apply to a loss from such disposition.

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LookLook--Through Rule:Through Rule:� Why. Owner’s pass-through business won’t be treated as

an investment. If sell interest – deemed like asset sale.

� How: “look-through”: Had entity its assets (“deemed sale”)

at FMV, what portion would be business income? (Prop. at FMV, what portion would be business income? (Prop.

Treas. Reg. Section 1.1411-7).

� Trade/business portion is excluded from NII “net gain from

disposition”.

� Complicated Computation - difficult to qualify.

� NOTE!: Does not apply to owner of C Corp!

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Look Through ComputationLook Through Computation� Summary

� T’s gain from sale of interest is bifurcated:

� if part of gain from sale relates to trade/business portion sold, total gain included in NII is reduced (negative adjustment)total gain included in NII is reduced (negative adjustment)

� T’s loss bifurcated: if part of loss from sale relates to trade/business sold, total loss is reduced – offset against other disposition gains is less (positive adjustment)

� �“Excess” = deemed investment gain/loss

� Note: Adjustment doesn’t increase total gain or total loss from sale of interest.

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LookLook--Through StepsThrough Steps� 1. Compute total gain/loss from disposition of interest.

� 2. Compute entity level total gain/loss from deemed FMV

sale;

� 3. Compute gain/loss deemed for each separate entity � 3. Compute gain/loss deemed for each separate entity

asset (including goodwill);

� 4. Multiply % interest sold x each gain/loss (the look

through);

� 5. Sort gain/loss between:

� (i) net investment income and

� (ii) excluded income (e.g., trade or business income.)

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Example Example –– AB AB P’shipP’ship –– all T/Ball T/B� AB Tax Consultants – B Has Basis of $75,000

B (75%) Sells Interest to C for

79

A (25%)

Interest to C for $90,000

AB Partnership

A/B Assets = $120K

Example Example –– All T/BAll T/B� Step 1. B’s Gain = $15,000. ($90,000 – 75,000)

� Step 2. AB Pship Built in Gain=$20,000 ($120 - $100K basis)

� B’s share (75%) = $15,000 (same)

� Step 3. Assume 100% business� Step 3. Assume 100% business

� � If B active in T/B, 100% active T/B Gain; and.

� Therefore 100% excluded from NII

� NII from disposition = $0.00

($15,000 minus $15,000 = $0.00).

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Example < 100% T/BExample < 100% T/B� Step 1: Same: B’s Gain = $15,000

� Step 2: Assume: AB Pship - $10,000 Built In Gain –adjusted basis = $110.00.

� Step 3: Assume has investment� Step 3: Assume has investment� Assets: Investment $5,000 gain (25%)

Tangible $15,000 gain (75%)

� Step 4: 75% x $5,000 = $3,50075% x $15,000 = $12,500)

� Step 5: $12,500 of B’s $15,000 Gain excluded T/B gain.� NII = $3,500 ($15,000 - $12,500 excluded)

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Example of Look Through LossExample of Look Through Loss

� Assume B sold at loss instead: $5,000 Loss (e.g.,

B’s basis is $95,000).

� Under either prior example, AB Pship’s (Built in � Under either prior example, AB Pship’s (Built in

Gain) = $20,000

� B’s share is $15,000

� $5,000 loss will be treated 100% as investment

loss.

� Deemed sale gain cannot increase the loss.

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Other Business Entity StrategiesOther Business Entity Strategies� Installment Sales

� Section 1031 Exchanges

� Charitable Donation of Appreciated Property

� Distributing investment assets� Distributing investment assets

� Successor Trusts (active Trustee) – see above

� Spreading Investment Income (Family Limited Partnerships & LLCS)

� Suitable Investments

� Managing Estate or Trust Distributions

� Creating Material Participation in Passive Activities

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Proposals and Changes on the Horizonthe Horizon

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Proposals and ChangesProposals and Changes� Joint Committee SET proposal (2005)

� Repeal limited partner exception

� Partner that does not materially participate pays SET only on reasonable compensation for servicesonly on reasonable compensation for services

� Investment income of a service partnership is subject to SET

� S corporation is treated as a partnership for SET purposes

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Proposals and ChangesProposals and Changes� American Jobs and Closing Tax Loopholes Act (2010)

� Impose SET on distributive share income of each shareholder of a “disqualified S corporation” who provides substantial services with respect to the professional service business of the S corporation

Disqualified S corporation:� Disqualified S corporation:� S corporation that is a partner in a partnership engaged in a

professional services business and substantially all activities are in connection with such partnership

� S corporation engaged in a professional services business if the principal asset is the reputation and skill of three or fewer employees

� Impose SET on any limited partner who provides substantial services with respect to a a partnership engaged in a professional services business

86

Proposals and ChangesProposals and Changes� CBO SET proposals (2012)

� Material participation standard� SET imposed on distributive share income of all partners who

materially participate

� Reasonable compensation standard� Reasonable compensation standard� SET imposed only on reasonable compensation paid to owners

(same as for S corporations)� Reduces SET revenues by estimated 58% (based on underreporting

observed for S corporations)

� Safe-harbor calculation of capital income� Apply a prescribed rate of return to balance sheet net operating

assets� Would not apply to S corporations� No accounting for intangibles and other off-balance sheet income

producing assets

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Proposals and ChangesProposals and Changes� Carried interests

� Would treat a partner’s distributive share of net income or net loss with respect to an “investment services partnership interest” (“ISPI”) as ordinary income or losspartnership interest” (“ISPI”) as ordinary income or loss

� ISPI = interest held by a person providing a substantial quantity of investment management services with respect to partnership specified assets (securities, real estate, partnership interests, and commodities)

� Amount characterized as ordinary income or loss is subject to SET

88

Proposals and ChangesProposals and Changes� Obama/Treasury proposal(pre-Fiscal Cliff)

� Return of Kintner Regs. – entity choice not for tax red’n.

� House Tax Reform Proposals (2013)

Option 1: revise rules for S Corps and P’ships� Option 1: revise rules for S Corps and P’ships

� Does not address SET

� Option 2: Adopt 1 set of rules for S Corps and P’ships

� Would require some rule characterizing distributive share income

� GOP (2014)

� SET applies to 100% distrib. share, GP, LP, S Corp, LLC

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Proposals and ChangesProposals and Changes� July 31, 2015 IRS 2015-2016 Priority Guidance Plan

� Final Regulations Under Section 469(h)(2) – Ltd P’ships

� Finalize open portions of Section 1411 regulations

� AICPA Proposals to Treasury� AICPA Proposals to Treasury

� Clarify material participation

� Clean up of regulations/statutory reform

� Obama’s Buffet Rule (30% min tax on TI > $1 million

� Bush Proposal – elim. 6.2% employee SET on seniors.

� No change to LPs/LLCs (Reform Corps & PIT)

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Proposals and ChangesProposals and Changes� AICPA requesting Treasury clarify material participation by a trust/estate:

� Incorporate the conclusions reached in the two court decisions;� Count all activities of any trustee or executor, irrespective of capacity and

irrespective of whether the individual owns an interest in the same;� Count the activities of employees and agents employed; � Allow Temp. Reg. § 1.469-5T(a) material participation tests to apply to

trusts/estates;� Allow Temp. Reg. § 1.469-5T(a) material participation tests to apply to

trusts/estates;� Deem period estate materially participating if owner materially participated b/4

death;� Treat trust/estate’s income character and beneficiary’s distributions the same;� Allow beneficiary participation in QSST to determines if QSST gain from a sale

of S Corp. stock is active or passive;� Allow both the S portion and the non-S portion of an ESBT to be a single trust

for §469 rules.� Allow a trust/estate to be a real estate professional under §469(c)(7) and state

how.

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Proposals and ChangesProposals and Changes� AICPA also requested the following:

� Threshold Amounts. Increase and allow inflation CPI; make optional simplified reporting available to more.

� Simplify Losses. Allow taxpayers to opt to include all � Simplify Losses. Allow taxpayers to opt to include all gain or excluding all loss disposition under look-through disposition rule for pass-through entities.

� Create Safe Harbor for Tiered. Provide a simplified safe harbor method for tiered pass-through dispositions

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Questions?Questions?

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Disclaimer� This document is not intended to provide advice on any

specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors.

� Any tax advice contained in this document and any attachments was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter.

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Cameron Hess Jim BrowneCameron HessWAGNER KIRKMAN BLAINE

KLOMPARENS & YOUMANS LLP

Mather, CA

916.920-5286 x810

[email protected]

Jim BrowneSTRASBURGER & PRICE, LLP

Dallas, TX

[email protected]

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